Bad News: The Real Wage is Rising

The U.S. rate of unemployment has been rising since March 2007, when it stood at 4.4 percent. In 2007 it rose slowly, then in 2008 and 2009 much more quickly. In August 2009 it reached 9.7 percent. The increase in unemployment represents for most people the most troubling aspect of the current recession.

However, during the past year, so much attention has been focused on the financial debacle in its various dimensions, and on the Fed’s and the Treasury’s efforts to deal with it, that the growing unemployment - now amounting to approximately 15 million persons - has become almost a footnote to the welter of troubles besetting the economy, and the labor market itself has received relatively little attention. Of course, the government’s “stimulus” spending programs purport to be aimed at restoring employment, and, if we subscribed to vulgar Keynesianism, we might expect them to do so.

Sound economists know, however, that, as some of them like to say, the labor market clears in the labor market, not in the product market or the bond market. When we seek to understand changes in the volume of employment (and by loose implication, the amount of unemployment), we are well advised to pay closest attention to what is happening in the labor market.

When we shift our gaze there, we behold an interesting, almost totally neglected, yet critical fact: while unemployment has been rising steadily, the real hourly wage for all workers employed in private industries has also been rising. According to the Bureau of Labor Statistics, the average hourly earnings of workers in all private industries rose from $17.23 in March 2007 (when the rate of unemployment was 4.4 percent) to $18.59 in July 2009 (when the rate of unemployment was 9.4 percent). During this same period, the consumer price index for all urban consumers rose by about 5 percent. Using this index to adjust the earnings data, we find that real hourly earnings rose by 2.8 percent during this 28-month period of deepening recession.

Even introductory economics courses teach students that the quantity of labor services demanded is a negative function of the real wage rate. If the real wage rate rises, other things being equal, employers will demand a smaller quantity of labor services. Thus, in view of the rise in the real wage during the past 28 months, we might well have expected employment to fall - and hence the unemployment rate to rise - simply because labor services were becoming more expensive.

However, other things were not equal during this period. Because the demand for labor services is derived from the demand for the goods and services that the laborers produce, and because that final demand has declined recently, the effect of the increase in the real wage has been magnified. The obvious question: why, in a situation of falling demand for labor services, has the real wage risen? This outcome is not what we would expect to see in a freely functioning labor market. Economists have advanced a variety of explanations to account for this anomalous occurrence (as observed on other occasions), but they have yet to agree on how it may be understood best.

We might well note, however, that an increase in the real wage at a time of deepening recession is an occurrence first observed in the United States between 1929 and 1933, during the Great Contraction. Economists from that time onward, including C. A. Phillips, T. F. McManus, and R. W. Nelson (1937), Murray Rothbard (1963), Lowell Gallaway and Richard Vedder (1993), and most recently Lee Ohanian (2009 unpublished), as well as yours truly (1987 and later works), have attributed a large part of the responsibility for the depth of the Great Contraction to this failure of the real wage rate to fall - as it invariably had fallen in economic downturns before 1929, including the sharp but brief contraction of 1920-21. It is scarcely reassuring to see that in the present contraction, the labor market is, in this regard, mimicking its behavior during the Great Contraction.

In 1937, Phillips, McManus, and Nelson wrote: “The brutal truth is that the standard of life for the American people has fallen drastically since 1929 for the simple reason that the policy of maintaining high wage rates has resulted in reduced employment and decreased production of the goods and services that constitute ‘real income’” (p. 225). Today, although we have not yet suffered the same reduction in living standards that our forebears suffered during the Great Depression, essentially the same brutal truth is haunting us again. Whether the increased real wage rate of the past two years reflects government policies or other causes, it has exacerbated the decline of real output. A reduction of the real wage rate would hasten a recovery from our present economic misfortunes.

More Comments:

Bill Woolsey -
9/9/2009

On an empirical note, the headline CPI increased 7% between March of 2007 and July of 2008. That is about 5% annual inflation. It then dropped 4.6% between July and December of 2008, which is a 10% annual rate of deflation. It has since that time risen about 2.5%, which is a 4% annual rate of inflation.

On a theoretical note, there were several macroeconomic events going on during the period. First, there was a shift from demand for single family houses to other goods. That process involves structural unemployment. While the adjustment process could be aided by higher prices and lower money wages (or at least slower nominal wage growth,) in the end, this is about changes in relative prices, the composition of output, and the allocation of labor. The adjustment could occur without any change in the growth path of real wages.

While this reallocation has been continuing, a secondary crisis was superimposed upon it starting a year ago. There was an increase in the demand for money, resulting in falling nominal expenditure. Just about every category of private expenditure dropped in the third quarter of 2008 and the first quarter of 2009.

An increase in the demand for money requires either a matching increase in the nominal quantity of money or lower prices. While that includes the prices of resources, such as labor, no change in real wages is needed. If some prices are more sticky than others, then the relative prices of more sticky prices will rise and the less sticky prices fall. If wages are especially sticky, then real wages would rise. Still, it isn't really the problem.

While some of the deflation in the headline CPI occurred when nominal expenditure was dropping, nominal income continued to drop in the first part of 2009, and headline CPI began to rise. In the second quarter of 2009, nominal expenditure stabilized. While nominal GDP fell a bit, total final sales actually increased. Still, total expenditure was about 5% below its long run growth path. For real expenditure to recover, prices and wages should fall. (Or, of course, nominal expenditure could rise.)

Most importantly, there was a huge run up in oil prices in the summer of 2008 that was reversed in the fall. That was the source of much of the change in the headline CPI. The higher oil prices should lower real wages. When oil prices come back down, real wages should rise again.

While Higgs focused solely on two end points, March 2007 and July of 2009, what has happen to this measure of wages? The trend growth rate of nominal wages has been about 3.6% per year between August 2004 and August 2008, with monthly wages deviating less than 1% from the trend growth rate. Currently, nominal wages are .75% below trend. As nominal income dropped in late 2008, nominal wages grew faster than trend (close to 4%) and reached a peak deviation of .33% above trend. The growth rate then slowed in early 2009, and soon nominal wages fell below trend.

Real wages, on the other hand, using the headline CPI deflator, have had a rougher ride. The trend growth rate is .84%. Real wages were nearly 3% below trend in July of 2008, and then nearly 3% above trend in December. Why? The change in oil prices and the resulting change in the headline CPI. Real wages remained nearly 1% above trend in July of 2009, however, the growth rate of real wages has been negative every month in 2009 until July. There was a a remarkable 9% annual rate of decrease in June of 2009. In July, real wages rose at a 5% annual rate.

Robert Higgs -
9/8/2009

When I wrote that before 1929, real wages had fallen during economic contractions, I had in mind especially what Phillips, McManus, and Nelson (PM&N) had said about this matter because I had read their book not long ago. Now, prompted by Jeff Hummel's comment, I have gone back and carefully read what PM&N wrote (on p. 230 of their book). First, the data they cite all apply to nominal manufacturing wage rates, which fell by 22 percent between the fourth quarter of 1920 and the fourth quarter of 1921. PM&N also cite an index of "prices" (which, although they do not identify it, is obviously the index of wholesale prices), which fell by 45 percent between the second quarter of 1920 and the third quarter of 1921. Thus, although they fail to draw the inference, the data they cite imply that the real wage rate in manufacturing rose substantially during this period of contraction. Instead of making this point, PM&N proceed to show that the nominal wage rate in manufacturing remained essentially constant between the third quarter of 1929 and the third quarter of 1930, and that during the next year the real wage in manufacturing fell by only 4 percent. So, I did not recall correctly what they had shown: they did NOT claim that the real wage fell during the 1920-21 contraction and, indeed, they cited data showing that it rose substantially. They emphasized that nominal wage rates were quite flexible downward in 1920-21, but not in 1929-31.

Vedder and Gallaway cite essentially the same data in their discussion of the 1920-21 contraction on p. 62 of their book, and they make clear that nominal wage rates in manufacturing fell greatly; they simply did not fall as much as wholesale prices.

Looking through Historical Statistics to find what data are available on this issue, one finds that the data are limited and, when available at all, problematic. Data are available for some firms (how representative?) in some manufacturing industries (how representative?). The notes state that the reporting firms tended to be larger ones, which makes one wonder whether their wage movements might have differed from the wage movements of smaller firms (such a difference seems to have existed in more recent times, as I recall). Moreover, manufacturing is only a part of the whole economy. In 1920, gainful workers in "manufacturing and hand trades" constituted only 26 percent of all gainful workers. One wonders, then, whether wage movements in manufacturing industries might have differed from wage movements elsewhere in the economy.

Also problematic is the analysts' use of the wholesale price index as the deflator for computation of "real" wage rates. Although one might argue that this is the proper index from the perspective of manufacturing-firm employers, it seems clear that the consumer price index is the proper one from the perspective of the employees. Analysis of the interaction of demand and supply in the labor market proceeds by taking the demand and supply functions each to be a function of "the" real wage. But which real wage? In some instances, it makes little difference, because the two indexes move closely together. But such was emphatically NOT the case in the 1920-21 contraction. Between 1920 and 1921, the wholesale price index fell by 37 percent; the consumer price index by only 11 percent. Between 1921 and 1922, the wholesale price index fell by less than 1 percent; the consumer price index fell by more than 6 percent. For the two-year period 1920-22, wholesale prices fell 37 percent, consumer prices 16 percent.

Historical Stats gives two different indexes of the nominal manufacturing wage rate: the one for production workers in 25 manufacturing industries fell by 18 percent between the second half of 1920 and the second half of 1922; the one for all manufacturing production workers fell by 13 percent between 1920 and 1922.

Given the data limitations and the need to take account of possibly substantial measurement errors in any event, it seems to me that we do not have enough data to say whether real wages rose or fell significantly during the 1920-21 contraction. As so often in the study of economic history, the analysts have settled for using manufacturing data (which occupied only a quarter of the labor force), allowing this tail to wag the dog of their analysis.

It is not amiss to note that a similar data difficulty afflicts many analyses of wage movements during the early 1930s. Again, analysts have placed too much reliance on manufacturing data, as if the whole economy were nothing but the manufacturing sector writ large &#8213; a doubtful proposition, indeed.

Jeffrey Rogers Hummel -
9/6/2009

Thanks for sharing this important observation. As far as I know, you are the first to have noted the behavior of real wages over the current recession.

But Gallaway and Vedder disagree with you real wages during the 1920-21 recession. This is from p. 62 of OUT OF WORK: "The substantial fall in prices greatly exceeded the drop in money wages, so real wages rose markedly to the third quarter of 1921. It would be an overstatement, however, to characterize money wages as rigid. After all, they did fall over 19 percent from the summer of 1920 to the end of 1921. It is more accurate to say that wages proved less flexible than prices."

Less Antman -
9/5/2009

Could the 3 increases in the minimum wage during the 2 year period ending July 2009 be part of the explanation? It has driven teenage unemployment over 25%, for example, and I would assume the destruction of low wage jobs increases the average wage rate of those not thrown out of work by the criminalization of work up to and including a rate of $7.24 per hour.